Reversal Trading

Market entry is a key part of any trading strategy. Opening a position at an advantageous price level, then riding momentum to profit, is a big part of the daily gameplan of many traders. Buying or selling a market when it is primed to turn definitively one way or the other can be risky, but is often a prescription for realising large gains.

What Is A Reversal?

A market reversal is the turning of a price trend, marked by a definitive high or low and subsequent directional move against set price action.

In a bullish market, a reversal is the falling of price from an absolute high established by an uptrend. Conversely, in a bearish market, a reversal consists of rising price action from an absolute low made during a preceding downtrend.

Reversals can be challenging to identify during formation, but they are easily recognisable after they develop. Listed below are the types of reversals in relation to rising and falling price action:

Uptrend: The uptrend is defined as a series of periodic higher highs and higher lows, with its eventual end marked by an absolute high price value. Reversal begins at the absolute high, and consists of price action trending downward, establishing a series of periodic lower highs and lower lows.

Downtrend: The downtrend is defined by a series of periodic lower highs and lower lows, with the exhaustion point being an absolute low price value. Reversal commences from the absolute low, and is marked by upward trending price action, establishing a series of periodic higher highs and higher lows.

Markets frequently change direction on intraday, daily and weekly bases. A market reversal may occur suddenly within seconds, or it may gradually take days or weeks to develop. No matter the duration involved, all that is needed for any market to undergo reversal is increased participation and an imbalance of supply and demand. As an abundance of buy orders hits the market, price rises; as order flow becomes dominated by sellers, price falls.

The underlying cause of the increased market participation present in a trend reversal may be relatively predictable or somewhat obscure. The following are three categorisations of reversal drivers:

Fundamentals: Market behaviour is typically dependent upon many factors that are specific to the product being traded. A shift in any of a market’s specific fundamentals may bring about considerable change in the dynamic of the market itself. For instance, in the trade of currencies on the forex, country-specific monetary policy greatly impacts exchange rate valuations. An announcement of revisions to a nation’s monetary policy may act as a catalyst for market reversal.

Technicals: Price action is the basis for all technical analysis and may influence the beginning and ending points of trending markets. Support and resistance levels, pivot points, moving averages and momentum oscillators often serve as precursors for reversal. In the event that a technical level creates ample market participation, an ongoing trend may become exhausted and be primed to enter reversal.

News Item: The scheduled release of official economic data or breaking news concerning an unexpected circumstance can create an atmosphere of uncertainty within the marketplace. Political upheaval, a natural disaster or an out-of-the-ordinary industrial report are capable of stemming a strong trend, sending price in the opposite direction.

It is important to note that a market reversal requires a sustained influx of either buyers or sellers to drive price opposite a prevailing trend. While there may be only one root cause, many times a reversal is a convergence of fundamentals, technicals and external stimuli such as a news item.

Trading Reversals

At first glance, the idea of entering the market on an absolute high or low seems to be an extremely advantageous way of trading. The possibility of buying or selling a market with supreme trade location is an attractive proposition, and one that can prove exceptionally lucrative.

By nature, reversal trading is a counter-trend methodology. Market entry is executed against price momentum, which greatly increases the chance of sustaining large drawdowns. If conventional wisdom says “the trend is your friend,” then reversal trading boldly states “the end of the trend is your friend.”

When implementing a trading strategy based upon market reversal, one is well advised to consider the following aspects of the trade:

Product/Market: Each market has unique characteristics. Some markets are prone to trend, while others typically consolidate. A market’s liquidity and traded volumes are major considerations when taking a position opposite the prevailing trend.

Trade Selection: In order to enter a position against a trending market with a reasonable expectation of success, one or more of the aforementioned elements of reversals must be present. Convergence of market fundamentals, technicals and external news releases may provide enough credence to the possibility of a directional change in price action.

Risk vs Reward: Adherence to positive risk vs reward expectations are an important part of accounting for the additional exposure present in taking a counter-trend position. The existence of a relevant stop loss point, as well as adequate potential profit, ensure that gains realised from successful reversal trades outweigh the failed ones.

Summary

Reversal trading is a risky, and sometimes dangerous, method of engaging the financial markets. The modern digital marketplace often moves with high degrees of speed and velocity; a trending market is capable of quickly wiping out a trader that is going against the grain at an inopportune time.

Becoming active in the market before a directional move in price is often the way to realising big gains, albeit on an infrequent basis. Strategies aimed at “selling tops” or “buying bottoms” are methods of capturing the big wins, but come with a good possibility of entering the market on a false high or low. However, through the implementation of proper risk controls and a comprehensive trading plan, reversals can be a valuable weapon in the trader’s arsenal.

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Past Performance: Past Performance is not an indicator of future results.

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